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Chapter 7:

Prospective
Analysis:
Valuation
Theory and
Concepts

Copyright (c) 2008 Thomson South-Western, a part of the


Thomson Corporation. Thomson, the Star logo, and
South-Western are trademarks used herein under license.

Chapter 7: Prospective Analysis:


Valuation Theory and Concepts
Palepu & Healy
Key Concepts in Chapter 7
• Forecasts (Ch. 6) are converted into estimates
of value.
• Discounted future dividends, cash flows, and
abnormal earnings may be used to estimate
value.
• Price-based multiples may also be used as
value estimates.
• No method by itself dominates any of the others.

Copyright (c) 2008 Thomson South-Western, a part of the


Thomson Corporation. Thomson, the Star logo, and
South-Western are trademarks used herein under license.

Chapter 7: Prospective Analysis:


Valuation Theory and Concepts
Palepu & Healy
Discounted Dividends Valuation
• The present value of future cash flows to
shareholders is the basis of the discounted
dividends method.
• This method is the basis for most theoretical
approaches to stock valuation, including the
other methods discussed in this chapter.

Where re is the cost of equity capital

Copyright (c) 2008 Thomson South-Western, a part of the


Thomson Corporation. Thomson, the Star logo, and
South-Western are trademarks used herein under license.

Chapter 7: Prospective Analysis:


Valuation Theory and Concepts
Palepu & Healy
Discounted Abnormal Earnings
• Abnormal earnings are those that differ from the
expected return: NIt – re * BVE0
• The discounted dividends method can be modified to
yield the following relationship:

Equity value = BVE0 + PV expected future abnormal


earnings

Copyright (c) 2008 Thomson South-Western, a part of the


Thomson Corporation. Thomson, the Star logo, and
South-Western are trademarks used herein under license.

Chapter 7: Prospective Analysis:


Valuation Theory and Concepts
Palepu & Healy
Accounting Methods and Discounted
Abnormal Earnings
• Analysts must recognize the impact of different
accounting methods on value estimates
• Valuations are based on earnings and book values
• Accounting choices affect earnings and book
values
• Double-entry bookkeeping is by nature selfcorrecting
• Strategic and accounting analyses are important steps
to precede abnormal earnings valuation.
Copyright (c) 2008 Thomson South-Western, a part of the
Thomson Corporation. Thomson, the Star logo, and
South-Western are trademarks used herein under license.

Chapter 7: Prospective Analysis:


Valuation Theory and Concepts
Palepu & Healy
Price Multiples Valuation
• Price multiple valuation methods are popular
because of their simplicity.

• Three steps are involved:


1. Select base measure
2. Calculate price multiples for comparable firms
3. Apply comparable firm multiple to firm analyzed

Copyright (c) 2008 Thomson South-Western, a part of the


Thomson Corporation. Thomson, the Star logo, and
South-Western are trademarks used herein under license.

Chapter 7: Prospective Analysis:


Valuation Theory and Concepts
Palepu & Healy
Precautions in Using
Price Multiples Valuation
• Selecting comparable firms
– It may be difficult to identify comparable firms, even
within an industry
– Industry averages may be used instead

• Firms with poor performance


– Marginal profitability or earnings shocks must be
considered

• Adjustments for leverage


– Take care to maintain consistency between numerator
and denominator
Copyright (c) 2008 Thomson South-Western, a part of the
Thomson Corporation. Thomson, the Star logo, and
South-Western are trademarks used herein under license.

Chapter 7: Prospective Analysis:


Valuation Theory and Concepts
Palepu & Healy
Determinants of Value to Book/Earnings
Multiples
• Value-to-book ratio is driven largely by:
– Magnitude of future abnormal ROEs
– Growth in book value

• Equity value-earnings can be derived from the


value-to-book formula:

Copyright (c) 2008 Thomson South-Western, a part of the


Thomson Corporation. Thomson, the Star logo, and
South-Western are trademarks used herein under license.

Chapter 7: Prospective Analysis:


Valuation Theory and Concepts
Palepu & Healy
ROE, Equity Growth, Price-to-Book Ratio,
and Price-Earnings Ratio

Copyright (c) 2008 Thomson South-Western, a part of the


Thomson Corporation. Thomson, the Star logo, and
South-Western are trademarks used herein under license.

Chapter 7: Prospective Analysis:


Valuation Theory and Concepts
Palepu & Healy
Shortcut Forms of Earnings-Based Valuation
• Assumptions may be made to simplify abnormal
earnings and equity value-to-book methods.
– Abnormal earnings: random walk and autoregressive
models
– ROE and Growth: ROE mean reversion, other
assumptions (e.g., decay)

Copyright (c) 2008 Thomson South-Western, a part of the


Thomson Corporation. Thomson, the Star logo, and
South-Western are trademarks used herein under license.

Chapter 7: Prospective Analysis:


Valuation Theory and Concepts
Palepu & Healy
Discounted Cash Flow Model
• Derived from the discounted dividends model
Equity value = PV free cash flows to equity claim
holders

Requires:
1. Forecasts of fee cash flows (usually 5 – 10 years)
2. Forecasts of fee cash flows beyond terminal year
3. Discounting free cash flows using the cost of equity

Copyright (c) 2008 Thomson South-Western, a part of the


Thomson Corporation. Thomson, the Star logo, and
South-Western are trademarks used herein under license.

Chapter 7: Prospective Analysis:


Valuation Theory and Concepts
Palepu & Healy
Comparing Valuation Methods
• No one method is superior to the others

• Using the same assumptions about firm fundamentals


should yield the same value estimates from either of the
three methods used.
• The three methods differ in the following aspects:
Focus – earnings or cash flow
Amount of analysis or structure required
Terminal value implications

Copyright (c) 2008 Thomson South-Western, a part of the


Thomson Corporation. Thomson, the Star logo, and
South-Western are trademarks used herein under license.

Chapter 7: Prospective Analysis:


Valuation Theory and Concepts
Palepu & Healy
Concluding Comments

The value of a stock is the present value of future


dividends.

Three methods are derived from this rule:


1. Discounted dividends
2. Abnormal earnings
3. Discounted cash flows

Each of these methods focuses the analyst’s attention


on different issues and requires a different level of
structure to develop forecasts of the underlying
dividends

Copyright (c) 2008 Thomson South-Western, a part of the


Thomson Corporation. Thomson, the Star logo, and
South-Western are trademarks used herein under license.

Chapter 7: Prospective Analysis:


Valuation Theory and Concepts
Palepu & Healy